P2B.2 Long Term Financial Management - Bonds Flashcards
Bond Definition
- Contractual agreement between the issuer (the debtor) and the bondholder (the creditor)
- Considered debt-financing.
- Less risky than stocks and generally equates to lower returns.
Capital Markets
- Primary: associated with the sale of new issues of securities. Similar to an IPO
- Secondary: associated with the sale of previously issued securities (subsequent sale).
Bond Valuation
- Based on expected future cash flows.
- Bond value changes opposite to change in market interest rate.
- Increase in market rate = decrease in bond value
- Decrease in market rate = increase in bond value
Bond Valuation Formula
PV of Bond = PV of Principal + PV of Interest
PV of Principal
p = 1/(1+i)n
PV of Interest
p = [1-1/(1+i)n]/i
Discount / Premium on Bond
Discount Market (effective) interest rate > Stated (coupon) interest rate
Premium Market (effective) interest rate < Stated (coupon) interest rate
Provisions for Bond Redemption
- Call: gives issuer right to redeem bond on specified date before maturity. Provides an organization flexibility in financing if interest rates fall.
- Refunding: allows issuer to replace bond with a lower coupon rate.
- Sinking Fund: amount set aside by issuer to retire bond when it matures. Interest rates are generally lower as the bondholder will gain comfort in knowing that the funds will be available when the bond matures.
Conversion Provision
- Gives owner the option to convert bonds into common stock.
- Lower cost of capital than non-convertible instruments due to conversion feature.
Advantages to the firm of using convertible bonds include deferring equity financing until equity prices are higher and a lower interest rate because of the convertible provision.
Disadvantage to the firm of convertible bonds is that investors may choose to continue their investment as a fixed-interest bond and assure their income stream rather than convert to stocks, on which the firm may choose not to pay out dividends.
Covenants / Restrictions
- Restrictions that are embedded in bond indenture.
- Affirmative (positive): favors the bondholder; such as providing collateral for bond.
- Restrictive (negative): limit actions of issuer; maintain certain financial ratios.
- A cross-default clause is a covenant that enables a lender to get out of a loan if the corporation fails to meet its obligations on any debt issue.
Junk Bonds
Junk bonds are bonds that have a rating of less than investment grade—less than BBB. Bonds can be rated below investment grade because of a lack of history for the company, the riskiness of a company’s enterprise, etc.
Serial Bonds
- Serial bonds are a package of bonds that mature in successive years (i.e., repayment of the principal is in a series of installments, not on the same date).
- The yield to maturity will depend on the year in which it matures.
- Investors have the advantage of being able to choose the maturity which suits their financial needs.
Relationship between inflation, interest rates and price of Financial Instruments
- Inflation: interest rates decrease and demand/spending for money increases.
- Deflation: interest rates increase and demand/spending for money decreases.
Carrying amount of Bond & Amortization
Issue price
Interest paid = par value x coupon rate
Interest expense = issue price x market rate
Amortization = interest expense - interest paid
Carrying value
Example:
Beginning carrying amount (issue price) $975,000
Interest paid ($1MM X 5.5%) $55,000
Interest expense ($975K X 7%) $68,250
Amortization of the premium $13,250
March 31st, 2020 carrying amount $988,250
Pure Expectations Theory
Assumes the yield curve is based on the expectations of the market of short term interest rates.
Liquidity Preference Theory
Assumes change interest rates over time are based on the belief that long term bonds tend to be less liquid and high risk
Market Segmentation Theory
Assumes supply and demand for long term and short term determine structure of interest rates in particular market
